So far, we don't seem to have gotten a heck of a lot of a return from the
massive amount of intellectual capital that we have invested in making,
exploring, and applying [DSGE] models. In principle, though, there's no
reason why they can't be useful.

One of the areas I cited was forecasting. In addition to the studies I cited
by Refet Gurkaynak, many people have criticized macro models for missing the big
recession of 2008Q4-2009. For example, in this
blog post, Volker Wieland and Maik Wolters demonstrate how DSGE models
failed to forecast the big recession, even after the financial crisis itself had
happened...

This would seem to be a problem.

But it's worth it to note that, since the 2008 crisis, the macro profession
does not seem to have dropped DSGE like a dirty dishrag. ... Why are they
not abandoning DSGE? Many "sociological" explanations are possible, of course -
herd behavior, sunk cost fallacy, hysteresis and heterogeneous human capital
(i.e. DSGE may be all they know how to do), and so on. But there's also another
possibility, which is that maybe DSGE models, augmented by financial frictions,
really do have promise as a technology.

The model they use is a combination of two existing models: 1) the famous and
popular Smets-Wouters
(2007) New Keynesian model that I discussed in my last post, and 2) the
"financial accelerator" model of Bernanke,
Gertler, and Gilchrist (1999). They find that this hybrid financial New
Keynesian model is able to predict the recession pretty well as of 2008Q3! Check
out these graphs (red lines are 2008Q3 forecasts, dotted black lines are real
events):

I don't know about you, but to me that looks pretty darn good!

I don't want to downplay or pooh-pooh this result. I want to see this
checked carefully, of course, with some tables that quantify the model's
forecasting performance, including its long-term forecasting
performance. I will need more convincing, as will the macroeconomics
profession and the world at large. And forecasting is, of course, not the
only purpose of
macro models. But this does look really good, and I think it supports my
statement that "in principle, there is no reason why [DSGEs] can't be
useful." ...

However, I do have an observation to make. The Bernanke et al. (1999)
financial-accelerator model has been around for quite a while. It was
certainly around well before the 2008 crisis. And we had certainly had
financial crises before, as had many other countries. Why was the Bernanke
model not widely used to warn of the economic dangers of a financial crisis?
Why was it not universally used for forecasting? Why are we only looking
carefully at financial frictions after they blew a giant gaping hole
in the world economy?

It seems to me that it must have to do with the scientific culture of
macroeconomics. If macro as a whole had demanded good quantitative results
from its models, then people would not have been satisfied with the
pre-crisis finance-less New Keynesian models, or with the RBC models before
them. They would have said "This approach might work, but it's not working
yet, let's keep changing things to see what does work." Of course, some
people said this, but apparently not enough.

Instead, my guess is that many people in the macro field were probably
content to use DSGE models for storytelling purposes, and had little hope
that the models could ever really forecast the actual economy. With low
expectations, people didn't push to improve the existing models as hard as
they might have. But that is just my guess; I wasn't really around.

So to people who want to throw DSGE in the dustbin of history, I say: You
might want to rethink that. But to people who view the del Negro paper as a
vindication of modern macro theory, I say: Why didn't we do this back in
2007? And are we condemned to "always fight the last war"?

My take on why these models weren't used is a bit different.

My argument all along has been that we had the tools and models to explain
what happened, but we didn't understand that this particular combination of
models -- standard DSGE augmented by financial frictions -- was the important
model to use. As I'll note below, part of the reason was empirical -- the
evidenced did matter (though it was not interpreted correctly) -- but the bigger
problem was that our arrogance caused us to overlook the important questions.

There are many, many "modules" we can plug into a model to make it do various
things. Need to propagate a shock, i.e. make it persist over time? Toss in an
adjustment cost of some sort (there are other ways to do this as well). Do you
need changes in monetary policy to affect real output? Insert a price, wage, or
information friction. And so on.

Unfortunately, adding every possible complication to make one grand model
that explains everything is way too hard and complex. That's not possible.
Instead, depending upon the questions we ask, we put these pieces together in
particular ways to isolate the important relationships, and ignore the more
trivial ones. This is the art of model building, to isolate what is important
and provide insight into the question of interest.

We could have put the model described above together before the crisis, all
of the pieces were there, and some people did things along these lines. But this
was not the model most people used. Why? Because we didn't think the question
was important. We didn't think that financial frictions were an important
feature of modern business cycles because technology and deregulation had mostly
solved this problem. If the banking system couldn't collapse, why build and
emphasize models that say it will? (The empirical evidence for the financial
frictions channel was a bit wobbly, and that was also part of the reason these
models were not emphasized. But that evidence was based upon normal times, not
deep recessions, and it didn't tell us as much as we thought about the
usefulness of models that incorporate financial frictions.)

Ex-post, it's easy to look back and say aha -- this was the model that would
have worked. Ex-ante, the problem is much harder. Will the next big recession be
driven by a financial collapse? If so, then a model like this might be useful.
But what if the shock comes from some other source? Is that shock in the model?
When the time comes, will we be asking the right questions, and hence building
models that can help to answer them, or will we be focused on the wrong thing --
fighting the last war? We have the tools and techniques to build all sorts of
models, but they won't do us much good if we aren't asking the right questions.

How do we do that? We must have a strong sense of history, I think, at a
minimum be able to look back and understand how various economic downturns
happened and be sure those "modules" are in the baseline model. And we also need
to have the humility to understand that we probably haven't progressed so much
that it (e.g. a financial collapse) can't happen again. History alone is not
enough, of course, new things can always happen -- things where history provides
little guidance -- but we should at least incorporate things we know can be
problematic.

It wasn't our tools and techniques that failed us prior to the Great
Recession. It was our arrogance, our belief that we had solved the problem of
financial meltdowns through financial innovation, deregulation, and the like
that closed our eyes to the important questions we should have been asking. We
are asking them now, but is that enough? What else should we be asking?

So far, we don't seem to have gotten a heck of a lot of a return from the
massive amount of intellectual capital that we have invested in making,
exploring, and applying [DSGE] models. In principle, though, there's no
reason why they can't be useful.

One of the areas I cited was forecasting. In addition to the studies I cited
by Refet Gurkaynak, many people have criticized macro models for missing the big
recession of 2008Q4-2009. For example, in this
blog post, Volker Wieland and Maik Wolters demonstrate how DSGE models
failed to forecast the big recession, even after the financial crisis itself had
happened...

This would seem to be a problem.

But it's worth it to note that, since the 2008 crisis, the macro profession
does not seem to have dropped DSGE like a dirty dishrag. ... Why are they
not abandoning DSGE? Many "sociological" explanations are possible, of course -
herd behavior, sunk cost fallacy, hysteresis and heterogeneous human capital
(i.e. DSGE may be all they know how to do), and so on. But there's also another
possibility, which is that maybe DSGE models, augmented by financial frictions,
really do have promise as a technology.

The model they use is a combination of two existing models: 1) the famous and
popular Smets-Wouters
(2007) New Keynesian model that I discussed in my last post, and 2) the
"financial accelerator" model of Bernanke,
Gertler, and Gilchrist (1999). They find that this hybrid financial New
Keynesian model is able to predict the recession pretty well as of 2008Q3! Check
out these graphs (red lines are 2008Q3 forecasts, dotted black lines are real
events):

I don't know about you, but to me that looks pretty darn good!

I don't want to downplay or pooh-pooh this result. I want to see this
checked carefully, of course, with some tables that quantify the model's
forecasting performance, including its long-term forecasting
performance. I will need more convincing, as will the macroeconomics
profession and the world at large. And forecasting is, of course, not the
only purpose of
macro models. But this does look really good, and I think it supports my
statement that "in principle, there is no reason why [DSGEs] can't be
useful." ...

However, I do have an observation to make. The Bernanke et al. (1999)
financial-accelerator model has been around for quite a while. It was
certainly around well before the 2008 crisis. And we had certainly had
financial crises before, as had many other countries. Why was the Bernanke
model not widely used to warn of the economic dangers of a financial crisis?
Why was it not universally used for forecasting? Why are we only looking
carefully at financial frictions after they blew a giant gaping hole
in the world economy?

It seems to me that it must have to do with the scientific culture of
macroeconomics. If macro as a whole had demanded good quantitative results
from its models, then people would not have been satisfied with the
pre-crisis finance-less New Keynesian models, or with the RBC models before
them. They would have said "This approach might work, but it's not working
yet, let's keep changing things to see what does work." Of course, some
people said this, but apparently not enough.

Instead, my guess is that many people in the macro field were probably
content to use DSGE models for storytelling purposes, and had little hope
that the models could ever really forecast the actual economy. With low
expectations, people didn't push to improve the existing models as hard as
they might have. But that is just my guess; I wasn't really around.

So to people who want to throw DSGE in the dustbin of history, I say: You
might want to rethink that. But to people who view the del Negro paper as a
vindication of modern macro theory, I say: Why didn't we do this back in
2007? And are we condemned to "always fight the last war"?

My take on why these models weren't used is a bit different.

My argument all along has been that we had the tools and models to explain
what happened, but we didn't understand that this particular combination of
models -- standard DSGE augmented by financial frictions -- was the important
model to use. As I'll note below, part of the reason was empirical -- the
evidenced did matter (though it was not interpreted correctly) -- but the bigger
problem was that our arrogance caused us to overlook the important questions.

There are many, many "modules" we can plug into a model to make it do various
things. Need to propagate a shock, i.e. make it persist over time? Toss in an
adjustment cost of some sort (there are other ways to do this as well). Do you
need changes in monetary policy to affect real output? Insert a price, wage, or
information friction. And so on.

Unfortunately, adding every possible complication to make one grand model
that explains everything is way too hard and complex. That's not possible.
Instead, depending upon the questions we ask, we put these pieces together in
particular ways to isolate the important relationships, and ignore the more
trivial ones. This is the art of model building, to isolate what is important
and provide insight into the question of interest.

We could have put the model described above together before the crisis, all
of the pieces were there, and some people did things along these lines. But this
was not the model most people used. Why? Because we didn't think the question
was important. We didn't think that financial frictions were an important
feature of modern business cycles because technology and deregulation had mostly
solved this problem. If the banking system couldn't collapse, why build and
emphasize models that say it will? (The empirical evidence for the financial
frictions channel was a bit wobbly, and that was also part of the reason these
models were not emphasized. But that evidence was based upon normal times, not
deep recessions, and it didn't tell us as much as we thought about the
usefulness of models that incorporate financial frictions.)

Ex-post, it's easy to look back and say aha -- this was the model that would
have worked. Ex-ante, the problem is much harder. Will the next big recession be
driven by a financial collapse? If so, then a model like this might be useful.
But what if the shock comes from some other source? Is that shock in the model?
When the time comes, will we be asking the right questions, and hence building
models that can help to answer them, or will we be focused on the wrong thing --
fighting the last war? We have the tools and techniques to build all sorts of
models, but they won't do us much good if we aren't asking the right questions.

How do we do that? We must have a strong sense of history, I think, at a
minimum be able to look back and understand how various economic downturns
happened and be sure those "modules" are in the baseline model. And we also need
to have the humility to understand that we probably haven't progressed so much
that it (e.g. a financial collapse) can't happen again. History alone is not
enough, of course, new things can always happen -- things where history provides
little guidance -- but we should at least incorporate things we know can be
problematic.

It wasn't our tools and techniques that failed us prior to the Great
Recession. It was our arrogance, our belief that we had solved the problem of
financial meltdowns through financial innovation, deregulation, and the like
that closed our eyes to the important questions we should have been asking. We
are asking them now, but is that enough? What else should we be asking?